Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

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Saturday, February 28, 2009

As usual, I like to share good stuff, which I think can be useful for my readers here. Check out this trading tips video!

I like this video, as it shares many practical trading tips in the real example, such as:* The use of Fibonacci Retracement* Identifying support and resistance* Where to place the stop loss* Estimating price target* What you can infer when the certain stock/market shows “abnormal” behavior as compared to the overall market sentiments.* etc.

I think I’d deem myself “selfish” if I don’t share this video with you, because I can learn many trading tips from this short video. Simply love it…How you can benefit from this too. :)

MAIN FACTORS THAT AFFECT OPTION'S TIME VALUEAs discussed in the previous post, Time Value of an option will be mainly affected by:1) Degree of Options Moneyness2) Implied Volatility (IV)3) Time Remaining to Expiration

Let’s see how all these factors affecting Time Value can be explained by “the level of uncertainty as to whether or not an option can finish ITM”.

1) Degree of Options MoneynessAs discussed in this post, Options Moneyness describes the relationship between an option’s Strike Price with stock price (i.e. where the Option’s Strike Price is in relation to the current stock price).

The farther the Option’s Strike Price to current stock price, the lower the time value will be.Therefore, since for ATM options, the option’s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.

Why is it so?Because ATM or near ATM options would have a higher uncertainty level as to whether or not the options can finish ITM, as compared to OTM & ITM options do.This uncertainty level can be explained by the how far an option’s strike price from the current stock price (i.e. degree of Options Moneyness).

For OTM options:The farther the option’s Strike Price from current stock price is (i.e. deeper OTM options), the more likely / higher probability that the OTM option cannot become ITM before or at expiration.Since it has “higher probability” that the deeper OTM options cannot finish ITM (or “lower probability” that the deeper OTM options can finish ITM), that means the options would have “lower level of uncertainty” as to whether or not it can finish ITM.This explains why deeper OTM options, the lower the option’s time value.

For ITM options:The farther the option’s Strike Price from current stock price is (i.e. deeper ITM options), the more likely / high probability that the ITM option can become ITM before or at expiration.Since it has “higher probability” that the deeper ITM options can finish ITM (or “lower probability” that the deeper ITM options cannot finish ITM), that means the options would have “lower level of uncertainty” as to whether or not it can finish ITM.This explains why deeper ITM options, the lower the option’s time value.

For ATM or near ATM options:As the option’s Strike Price is equal to or near current stock price, it is still very uncertain if the option can or cannot become ITM before or at expiration.In other words, ATM or near ATM options have “higher level of uncertainty” as to whether the options can or cannot finish ITM. As a result, their time value will be higher.

Continue to Part 3: Main Factors – Implied Volatility & Time to Expiration.

Sunday, February 15, 2009

Market-If-Touched (MIT) is an order to buy / sell a security when the market reaches / touches a predetermined price level (i.e. Trigger Price) that is lower than current price for buy order, or higher than current price for sell order.This order is held in the system until the Trigger Price is touched. Once Trigger Price is touched, the order will be submitted as a Market Order to buy / sell at the best available market price.The same advantage & disadvantage of Market Order apply to MIT Order as well.

There are 2 types of MIT Order:

a) Buy Market-If-Touched (Buy MIT) order is an order to buy a security at the best available price if the market price of the security goes down to the Trigger Price, which is lower than current market price of the security.Once the Trigger Price is touched, the order will turn to a Market Buy Order, to buy at the best available market price.

b) Sell Market-If-Touched (Sell MIT) order is an order to sell a security at the best available price if the market price of the security goes up to the Trigger Price, which is higher than current market price of the security.Once the Trigger Price is touched, the order will turn to a Market Sell Order, to sell at the best available market price.

Example:A trader identifies an ascending triangle pattern in Stock ABC. He believes that if the price rises and breaks a certain price benchmark (i.e. the breakout level of the ascending triangle pattern), it will continue to increase further. However, he also expects that the stock will make pullback first to the breakout level before continuing its upward movement.

Suppose that the breakout price is $80. The stock has already broken out that level, and is currently trading at $82. The trader wants to enter into a long position to buy at any market price, only if the price makes a pullback to the breakout level. He then submits a Buy MIT order with a Trigger Price at $80 (lower than current price of $82). His order will remain in the system until the Trigger Price is touched. If the stock does make a pullback and touches $80, the order will then be submitted as a Market Order to buy the stock at the prevailing market price at that time.

As can be seen in the above formula, it is only ITM options that have Intrinsic Value component, whose value is simply the difference between option’s strike price and current stock price.Whereas for ATM & OTM options, Time Value is the only component of the options’ price / premium.

Time value can be viewed as “the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)”.The more uncertain, the higher the time value will be.

In other words, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.When it is more certain that an option can or cannot finish ITM, the time value will be lower.In other words, when an option has “higher or lower probability” that it can or cannot become ITM before or at expiration, that means the “level of uncertainty” will be lower.So, it is the level of uncertainty that matters, not whether it has higher or lower probability to finish ITM or not finish ITM.

In the next post, we’ll discuss further with more elaboration and examples about how this “level of uncertainty” could explain option’s time value.

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